Thursday, May 18, 2006

Diversification is the mantra of the prudent investor, but if you were hypothetically limited to just one stock-market holding, what would it be?

You'd hope for a solid if not spectacular long-term return, probably with a reliable income component on top of share-price gains. You'd also want as little risk as possible.

If you think nothing like this exists outside the Twilight Zone, then submitted for your consideration are ... Canadian bank stocks.

With a single investment, thousands of highly trained people work to maximize your return on equity, in a vast enterprise ranging from credit cards and car loans to industrial finance, investment dealing and the far frontiers of trading in commodities, currencies and derivatives.

And while equity mutual funds typically charge at least two per cent a year to manage your money, the banks - which incidentally operate many of the country's largest funds - pay dividends worth three per cent or more, and have a long record of increasing those payouts.

For investors who like to sleep soundly at night, all the big Canadian banks are solidly capitalized and use sophisticated risk-management techniques.

They also tend to recover adroitly from miscues: CIBC shares, for instance, tumbled from over $80 to under $70 last August after $2.8 billion in Enron-related charges, but revived to hit $86 in March and currently trade in the $82 range.

For the record, this is up from $23 a decade ago, representing a compound annual return of 13.6 per cent, not counting dividends.

The biggest bank, the Royal boasts a 10-year compound annual stock-price gain of 19 per cent, compared with 18 per cent for Scotiabank, 17 per cent for Toronto-Dominion and 14 per cent for Bank of Montreal.

"They're not going to run up $4 or $5 a share in a day . . . it's a more subdued sector," observes Fred Ketchen, director of equity trading at Scotiabank's Scotia Capital division.

However, "If I was going to buy one stock, it would be a major bank," Ketchen says.

"The reason for that would be their record of growth, and their record of dividends. I think that over the last 10 years every bank, except TD which just missed one year, has increased its dividend at least once every year."

That's not to say bank shares are bulletproof.

"If you go back to the first part of 1998, the bank index in general was down 47 per cent over a six-month period," says Tom Kersting, a financial services analyst at Edward Jones in St. Louis.

"They can go down, they do go down, and they don't always snap right back - when they went down the 47 per cent in 1998 it took 18 months just to get back to break-even."

John Kinsey of Caldwell Securities notes that the past three or four years have been a golden age for the banks, thanks to low interest rates, solid economic growth and small loan losses.

Now their profit growth is slowing, Kinsey says, and he expects annual percentage price gains for bank stocks to decline from the high double digits to the high single digits, which including dividends would be "a little over 10 per cent or so - and that's not too bad, considering the (low) risk."

In fact, it doubles your money in seven years or less.

As for the risks, "clearly the economy and interest rates are the short-term variables that tend to impact the bank stocks as much or more than any other sector," says Kersting.

He recently removed "buy" ratings from the five biggest Canadian banks, rating them all "hold."

"We still think they're fabulous companies; however, we think that the stocks got a little ahead of themselves and were pretty pricey."

Since Edward Jones shifted its sectoral call to "neutral" in March, the sector has pulled back, with Scotiabank and BMO down by as much as 10 per cent.

"I still think the stocks are toward the upper end of their historical valuation levels," Kersting said.

But for Scotia's Ketchen, the recent decline suggests "this would probably be a good time to pick your favourite bank" ahead of their quarterly earnings reports, which begin May 24.

Merrill Lynch analyst Andre-Philippe Hardy recently raised his estimates for the quarter. But Hardy also warned that historically high price multiples, now about 12 times expected annual earnings, are "unlikely to expand," and he rates all five big banks "neutral."

Regardless of near-term fluctuations, Ketchen declares: "I'm going to live with the banks because they have treated me well for 25 years and I don't know what's going to make them stop."

As Kersting observes: "They're very well run companies. They're large, they're well capitalized, diversified for the most part. Long term, for the financial services industry there are some favourable drivers," including the needs of aging baby boomers and new opportunities in a globalizing economy.

And whatever happens, bank shares pay an unquantifiable psychological benefit: the more you detest getting nickel-dimed by account fees, the happier you'll be as a part-owner of the bank.